Barron's Streetwise - Don’t Lick That Frog—the Pull and Peril of a 17% Yield

Episode Date: October 27, 2023

Jack discusses mortgage REITs and answers a listener question about collectibles.  Learn more about your ad choices. Visit megaphone.fm/adchoices

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annoying people who told you about the house they got a few years ago where they locked it in at two and five eighths percent and you know, what have you. You're not supposed to tell people about the low mortgage rate you scored, by the way, because some people are really bummed out about it. Meta. That's me. I don't want to spill too many of the beans here, but you're one of these people, right? By the way, this is the Barron Streetwise Podcast. I am Jack Howe. You're our audio producer, MetaLootsoft. And, you know, you're a city dweller who you've got some plans and they've been shuffled a little bit by the rise in the mortgage rate.

Fair to say? Fair to say. I'm one of those sensitive people that you can't brag to about your low mortgage rate. Right. Rate sensitive and just plain sensitive. Yes. And if you did the math a few years ago and then you look again now on that monthly mortgage payment, it could be a difference, an increase of thousands of dollars.

Fair to say? Fair to say. It's a tough situation. I don't know the next move for rates. We have talked in the past about house prices. What's next for home buyers. It's a tough situation. I don't know the next move for rates. We have talked in the past about house prices. What's next for home buyers? That's not the topic we're going to talk about today. We're talking about something very specific to investors. It's something called a mortgage REIT, but it's related to these changes in interest rates. There is, for example example a large company in midtown manhattan it's called annalee capital management

and it has been in the business of investing in mortgages for more than 25 years this is a what you would call a blue chip in this business and the dividend yield on this company on shares of this company was recently 17 think Think about that for a minute. That's almost double what the historical, you know, average yearly return has been for the stock market. If you're an investor living off of a portfolio, a financial planner would tell you, you can safely take out 4% a year, maybe. So this is four times that much income. This is like, you know, you put it all in this thing, you can retire early. Don't do that, by the way. I want to stress that part.

Don't do that. I wrote about these things recently for Barron's Magazine, and I compared anytime you see a double digit yield on a stock, I think of that as like seeing bright colors on a rainforest frog. What do the bright colors tell us? It's nature's way of telling you, you can look at this thing, but please don't lick it, because it's probably toxic. It could be secreting enough toxin right now

to kill 200 monkeys. I read that on the internet. I think it was National Geographic or somewhere like that. You can lick it if you're an experienced herpetologist. That's someone who knows a lot about reptiles and amphibians. Probably knows which frogs to lick. Also, some animals evolve with an immunity to this toxin. There's a snake in South America called the fire-bellied snake and that's the only natural predator of the golden poison dart frog. So it runs around licking the frogs? I think it's eating.

I mean, it's licking them in the course of eating them. Probably both. I'm also guessing, and I'm no herpetologist, that if you are a golden poison dart frog, you could probably lick another golden poison dart frog. But aside from those exemptions, you know, don't lick bright frogs because they could be dangerous. And that's what big dividend yields tell me. They can foretell trouble.

I'll give you an example. 20 years ago, you know, a company called Eastman Kodak, Meta? No. Way back when, when people took pictures, this was before cameras were really in phones. They used these cameras that had things in them called film. It was these plasticky rolls. And you would take your plasticky roll and you'd drop it off at a little hut at a parking lot somewhere.

And there was a person in there who would send it to another person, a total stranger, who had a bunch of chemicals. And they would turn your plasticky roll into pictures. And so total strangers would definitely see your pictures before you got them. But then, you know, you show up sometime later and you pick up prints of your pictures. That's how the picture-taking process worked. Anyhow, Eastman Kodak, people saw, even before smartphones, the writing on the wall for film. You know, digital cameras were taken over. And so Eastman Kodak, just over 20 years ago, it had a 6.7% dividend yield and it had paid

a dividend every year since 1902. So you say, hey, I know the film business isn't what it used to be, but look, what more dependable dividend payer has there been over the years? And about that time, Kodak cut the dividend by nearly three quarters. Oh, I know the company Kodak. I heard Eastman. Yes. I think the company is founded by a guy named Eastman. And so the name was Eastman Kodak. Anyhow, they cut that dividend and the shares dropped 15 percent in a day. And that was only the beginning. The company, you know, years later, there was a bankruptcy and restructuring. So things didn't go well for someone who bought into that juicy yield on Kodak. And that's a sort of risk that you take when you buy into a yield that just looks

way away from what other companies and quality investments are paying. And certainly 17% is one of those yields. But these are mortgages, right? They're buying a portfolio mortgage. Mortgages are not film. Mortgages are not going to become obsolete, right? And plus, the dividend was already cut early this year. And the stock price has already been pummeled, really. It's lost almost half its value over three years.

Also, last month, UBS upgraded the stock to buy. It was $21 a share at the time. Now it's $15 a share. As they say on Wall Street, that call was early. Or as they also say, if you liked it at 21, you'll love it at 15. And JP Morgan seems to love it because it wrote a report on mortgage REITs this past week. And it said, buy the dip on the mortgage REITs in general and annually in particular. So they're saying this frog is actually not that bright colored. It's quite neutral. They're saying, lick this frog is actually not that bright colored. It's quite neutral. They're saying lick this frog. Lick it right now. Forget about it. Bright colors or not, start licking. I'm paraphrasing.

So look, I want to examine this case for anyone who sees these astonishing yields and is thinking about this and they want to know what are the risks? What could go wrong? what could go right. And for a start, I'll just contrast the recent opinions of UBS and JP Morgan with that of Edward Jones. It published a report over summer, basically said, don't buy these things, just in general. These things are not good for individual investors. We'll look at what it doesn't like. Okay, the first thing to know about a mortgage REIT is it's a REIT, right? Just like the ones we've talked about where they buy physical properties and they collect rents and they pass those rents, net of their expenses, onto shareholders as dividends. We call those equity REITs. Mortgage REITs don't generally buy property, although there are hybrids that do both.

Mortgage REITs make loans to developers, both commercial and residential. Or sometimes they just buy mortgage securities, including from government-backed agencies. So sometimes the things they're buying are quite safe from a credit risk perspective, but there's still a lot of risk. And it's mostly related to interest rates, changes in interest rates, different skews in interest rates. For example, when rates are very low, there's a risk that people would do what with their mortgages? They'd refinance them. And if you're running a portfolio of mortgage securities, you get securities that are being taken away from you as people refinance, and then you got to put money to work at lower rates.

That's a risk. There's also a risk as interest rates rise, because one of the things that mortgage rates do is they borrow short and they lend long, just the way banks do. They make their money on a lending spread. They might, for example, borrow for less than six months at a time, and they might buy securities with maturities that are, let's say, two to five years. And if securities pay more than it cost them to borrow the money, hopefully that's a spread. And they can amplify that spread with the use of leverage. They tend to use more leverage than equity REITs, I would say two to three times as much

as a percentage of assets. So if rates rise, the value of existing mortgage securities can get hurt and also lending spreads can get squished depending on how exactly rates rise. It's particularly troubling if short rates rise higher than long rates. That's called an inverted yield curve, and that's exactly what we've had recently. There are all sorts of other things that can happen to affect the value of these portfolios, and some of them are quite arbitrary. For example, maybe the economy falls on hard times.

Maybe the Federal Reserve says, we want to take action to make things easier for people. And instead of just cutting rates, which affects the short end of interest rates, we're going to buy up securities, which would affect the long end. It would push the prices of those securities up and the yields down. That's one way to bring down, for example, mortgage rates, which could help people afford homes. And that is precisely what the Fed did at times over the past 15 years. That's called quantitative easing. And that is the opposite of what it has been doing now.

It's been pursuing quantitative tightening by selling off some of those securities, including mortgage securities. And that has been another drag on the value of these portfolios. If you're a portfolio manager, it's hard to predict exactly what the Fed is going to want to do five years from now concerning quantitative easing or tightening or mortgage securities. But one thought is that this has been a pretty wild ride for rates in recent years. And so with the Fed getting out of the mortgage buying and mortgage owning business, maybe it'll stay out for a while. And maybe that will help to smooth some of the booms and busts that we've seen in the business of investing in

mortgages. That's part of the case that UBS made last month. I'll come to that in just a moment. One or two more notes on the risks. Mortgage REITs, they also sometimes issue shares when they want to expand. And when you issue shares, it can dilute the value of existing shares. And also dividend payments can be volatile. Maybe volatile isn't the word. Dividends for most stocks are seen as kind of a commitment with mortgage rates. There may be a light suggestion, maybe a slide whistle. I don't know what you would compare them to. They're not terribly dependable. Annalie, for example, has cut its dividend payments 16 times in 16 years. Payments have gone up and down. Also, and I feel like this one is kind of a biggie, returns generally stink for mortgage REITs. If you look at an index of mortgage REITs over 20 years that ran through this past June,

they experienced average annual price declines of 9.6%. The total returns, once you added in all those dividends, were positive, but only 1.2% per year on average. If you compare that with equity REITs, they experienced average annual price gains of 4.1% and total returns, including dividends, of 8.6%. So the dividends for those equity REITs were a lot smaller, but at the end of 20 years, your total returns were much, much larger. And that's why Edward Jones pretty much comes down in the camp of avoid mortgage REITs altogether for the most part if you're an ordinary individual investor and pick equity REITs instead.

Okay, so back to UBS and their case. On September 18th, they upgraded Annalie, among others, to a buy rating, basically saying that the damage has already been done here. We've already seen a sharp rise in rates. We've already seen the Fed selling mortgage securities. The book values of securities for these portfolios, in other words, the accounting value of them, has already been beaten up. And lending spreads for mortgage-backed securities at the time were surprisingly healthy. They were around 1.6 percentage points on average. The long-term average is closer to a point.

I know that doesn't sound like a huge spread, but again, you can expand the returns with the use of leverage. So UBS said with the Fed getting out of the mortgage-owning business, they thought that returns over time would maybe become smoother. And they predicted a 10% rise in the portfolio value of these mortgages and a 30% return for the shares within a year. And that, as I said, hasn't worked out. Mortgage rates have pushed higher and mortgage REIT shares have fallen more, a lot more in

some cases. And we noted recently in this podcast that today's mortgage rates, they're much higher than we remember, but they're not especially high relative to the whole history of mortgage rates that we have going back to the early 1970s. They're pretty ordinary, but what's to say that they can't overshoot from ordinary levels and push even higher. Well, JP Morgan says there's going to be some more volatility in the near term for these mortgage REITs, but they see an opportunity. This past week, they wrote, we believe Resi MREITs, that's what the cool kids call residential mortgage REITs. We believe REZI MREITs offer a favorable asymmetrical risk reward profile. Income from mid-teens dividend yields should dampen near-term

risk as investors wait for TBV appreciation slash multiple expansion when QT abates. Now, TBV is tangible book value. And when they say appreciation slash multiple expansion, they mean that book values could rise and also investors could be willing to pay a higher multiple of those book values. Now, when I say appreciation slash multiple expansion, they mean both that book values could rise and that investors could become willing to pay higher multiples of those book values when they buy shares. And when they talk about QT abating, that just means the Fed selling those securities. So that's it. That's their case.

They say buy here and they say basically, although there's going to be more volatility, look, you're starting off with this gigantic yield and that yield is going to help offset some of the price volatility, and you hold for a while until these loan portfolios come back, and you're going to make out okay. And maybe they're right. In the course of predicting the bottom for these mortgage REITs, some lucky or highly skilled or lucky unskilled soul is going to get the timing right and call the bottom,

and then they're going to predict a trade right and call the bottom. And then they're going to predict a trade that will make a lot of money for investors. I don't know if this is that moment. I'm not certainly recommending that trade for anyone. I think these things are risky. I mean, for a long-term buy and hold investor, I don't think, you know, I'm with Edward Jones. I don't think you really want much of a part of mortgage REITs. If you're a trader and you have particular knowledge of this industry, or you want to make some sort of aggressive bet on what's going to happen with rates or mortgages, maybe you lick this toad, like JP Morgan says. Right, Meta?

I don't think I'm doing it. Smart. I did offer, how shall I say, in the column I offered and one additional piece of advice on not so much this industry as Annalie in particular. The thing about Annalie is the name is spelled A-N-N-A-L-Y. And sometimes, you know how you only ever read a thing, you never say it. And then the first time you go to say it, you get halfway through a sentence, you realize you don't know how to pronounce it, and then sometimes you pronounce it wrong. Well, that happens a lot with Annalie, and there is some risk of a fairly catastrophic mispronunciation in this case. I just cautioned people in the column that, you know, before

launching into a conversation with a friend about the merits of taking a stake in this company. You should just note that the stress is on the first syllable, but it takes a short vowel sound like the name Ann. Annalee. Okay. That's a, what do we call that? A public service announcement? I think so. This is, I'm a 51 year old man, by the way.

Let me remind you now Madda my podcasting super sense that has been honed by these past few years of doing these things is telling me that this is a good time for a break am I right? Impressive yes it is time for a break and when we come back,

we're going to talk about collectibles. See you in a minute. Welcome back, Mede. I understand we have a listener question. We do. It's from Rasmus. Hi, Jack and Mede. A question all the way from Denmark. In a recent episode, you talked about investing in art. That episode made me think about other ways to invest outside the stock market. So what about cars, wine, and other collectibles? Are there specific trends or niches that are currently showing promising potential for investors and how to get started. Thank you for a great show. Thank you, Rasmus from Denmark. And Meta from Denmark is definitely not showing bias and pushing our questions from Denmark straight to the front of the line. I'm sure of it. Now, collectibles. There are many different opinions on this subject, but the thing to keep in mind is that I'm right and

everyone else is wrong. Is that fair to know? Well, look, I have described myself as almost a financial nudist. I think you can get away with next to nothing, very little of what Wall Street packages and puts a fee on and says that you need in your investment portfolio. You need stocks, plenty of stocks. You need bonds and maybe you need a spinch of cash. And that's pretty much it. You need real estate. Well, stocks represent businesses and businesses own real estate. So you've already got some if you own a stock index fund. Do you need commodities? I don't think so. I think some of those businesses mine things out of the ground. You've already got some commodities. Some of them

drill for oil. But more broadly than that, the way I think about it is, if you think of everything that you can do with your money as an investor, it all falls into a few different categories. One is you can buy a business. That's what you do when you buy stocks or when you go out and you start a business. Two is you can loan money to someone for interest. That's what you do when you buy stocks or when you go out and you start a business. Two is you can loan money to someone for interest. That's what you do when you buy bonds. And three is you can also buy stuff. Literally, you can buy gold bars and then you can hope that those gold bars become more

valuable over time. Does Bitcoin count as stuff? Bitcoin is definitely stuff. It's abstract digital stuff that you can't hold in your hand, but it's still stuff. Now, there's a subset of stuff called collectibles, which people buy for their rarity or the fact that there are communities of others who enjoy these things around the world, and you can learn about them and so forth. And I get pitches every day in my email box from somebody who wants to tell me

about the special opportunity and different collectibles. There's also a group called Knight Frank, which tracks prices for collectibles. In their second quarter report this year, they said art is in the lead for this year. They got a chart here showing that fine art is apparently up 30% this year. That's better than watches and jewelry, which are up 10%, or coins, 8%. Cars and wine, 5%. Colored diamonds, 4%. Handbags, 1%. Furniture apparently has been treading water. Rare whiskey bottles have lost a little ground. What's striking there is that if you look over the past 10 years on their chart, rare whiskey is in the lead up 322 percent. I'm assuming when they say rare whiskey bottles are talking about bottles with whiskey in them. You can also buy casks with whiskey in them. There's an index of

casks with whiskey in them. The BCkeyCast Index. There's indexes for just about everything. Usually when you see a pitch for buying collectibles, they talk about spectacular past returns or about potential to hedge a portfolio against inflation. But how do you know? How do you know that the numbers you've seen in the recent past are representative of the returns you can expect from that collectible? Or how do you know that individual items within that collectible group will perform similarly? That same group that tracks price is Knight Frank. They have a chart showing classic car returns this year, January through June. Lamborghinis up 9%. Ferraris down 15%. Why? I don't know. I mean, they're both fast

and Italian and hard to fit into. Why did blue diamond prices go up 2% for the year through the second quarter of this year, while pink diamonds went up 3% and yellow diamonds went up 6%. Why were Bordeaux prices up 6% over the 12 months through early July, while burgundy prices were down 9%? Let me sniff these corks real quick. I don't know. And why is that a reversal of the 10-year trend, where burgundy was up 214% and Bordeaux was up only 54%. I don't know. But isn't that the same of companies? One chip company stock go up because they solve their supply chain issues and another chip company stock go down because people don't like their new CEO.

It is definitely true. And in the short run, stock price movements can seem to make no sense. In the long run, businesses produce something of economic value. They produce cash flows. There's a saying from Warren Buffett in one of his letters to shareholders decades ago. He says, in the short run, the market is a voting machine, but in the long run, it's a weighing machine, which basically means changes in popularity can lead to short-term swings in share prices, but longer term, it's the economic output of the businesses that matter more. And that's the problem with collectibles. There's no economic output. There's no cashflow. There's no revenues. There's no dividends. There's just stuff sitting

there. And then there's different opinions on what that stuff is worth. Let me see if I can give you like a mathematical framework for how I think about this. First of all, the argument that collectibles are a hedge against inflation. Forget about it. Inflation is a rise in the cost of goods and services over time. Businesses are a good enough hedge against inflation in the sense that their leaders have to think up ways to stay ahead of it in order to produce positive returns. Absent short-term swings in supply and demand, stuff should be expected to rise at the rate of inflation over time. I mean, that's what inflation is, right? CPI, you look at it,

it's an index of stuff and services. And so if you're telling me that whiskey is a good hedge against inflation, well, yeah, booze is literally part of CPI, but I'm not sure that's the best thing to preserve my buying power over time. Also, by the way, and this is probably a subject for another day, but CPI is an arbitrary index of goods and services that matches the buying pattern of no actual individual person. It's just a theoretical consumption pattern. You might buy more booze than CPI has or less booze than CPI has. You've got your own personal rate of inflation that you're going to experience over the next five or 10 years. And that's really the number that you want to keep up with as an investor. Okay, back to stuff. Here's how I think about the return. We have to build a little formula.

Return equals, and the first thing we're going to put in there is the rate of inflation, because we're talking about stuff and that's what inflation is. Now we're going to add or subtract from that as we go along. The next component is those short-term swings in supply and demand. And to predict those, I don't know, you have to be an industry expert, but even if you are, you might have trouble. If you're the kind of person who just knew back in January that Lamborghinis were going to go up 9%, but Ferraris were going to go down 15%. Maybe you've got a knack for predicting those swings in cars. If you're just a generalist looking to buy collectibles, you're up against some pretty smart people trying to predict these industry trends,

and even they don't always get it right. Okay, so that's our second component. That's one that's really going to drive the most of the return on this thing over the next year or two. To my mind, it's totally random and unpredictable. really going to drive the most of the return on this thing over the next year or two. To my mind, it's totally random and unpredictable. Number three, carrying costs or lump maintenance in there. Let's say you're buying fine art, really expensive art. You're spending millions of dollars. You're going to want to protect these paintings. You need to keep them somewhere safe. You need security. You need climate control. You need, I don't even know what you need because I don't own million dollar paintings, but you need a lot of stuff and that stuff is expensive.

And that's a carrying cost of that collectible. So if we're just talking about returns, you've got to subtract that from your returns. Now, I want you to adjust those carrying costs for what I'll call utility, what you can also call joy. Maybe you just like collecting this stuff. Maybe you see on the Knight Frank chart for watches that Rolexes went up 10% over the 12 months through June. Cartier went up 12%, but Patek Philippe went up only 7%. And maybe you

don't care at all, because the thing you love to do more than anything in this world is take your 12 Patek Philippe watches, strap six on each arm, and march around your home and say, look at me, I'm the mayor of Patek Philippeville. How much is that worth to you? How much joy do you get from that? You've got to put a number in there to you? How much joy do you get from that? You've got to put a number in there to account for that. So if you have fun collecting this stuff, that's got to go in there somewhere and it's a hard thing to measure. You can't put a value in knowing the time. What am I leaving out? Maintenance, carrying costs, short-term swings, fun.

Oh, I know one thing I forgot to put in there, and it's a very important thing. It might be the most important thing when we're talking about these 10-year returns or returns for the past couple of decades, and that is interest rates. Now, these things we're talking about don't pay any interest. So what does that matter? It matters because if you're going to spend a million and a half dollars to put some Patek Philippe's up one arm and another million and a half to go down the other, that's money that you can't put in treasuries right now paying 5%. It's opportunity cost. Opportunity cost. But if we go back just a few years, that was money that you couldn't put in treasuries paying next to zero. So the opportunity costs were very low. When the opportunity costs are very low, you might as well put money in stuff. You're not getting much from the bank or from treasuries anyway. And that, I think, is why we see some

of these eye-popping numbers for how collectibles have performed over recent decades. Now that interest rates are significantly higher, I'm not sure we're going to see those same numbers going forward. I think we're going to look back on that period and say, wow, that was a heck of a time to collect just about anything, but returns since then have stunk. It depends. You can't be sure. Some of these things are driven by the economic behavior of rich people and rich people don't necessarily behave like the rest of us when it comes to money. So we'll see.

So Rasmus, I guess my advice for you would be, I don't know which categories are going to perform well, but if there's one that you should invest in, it should be one that brings you joy. And we should probably stop using the word invest. You shouldn't think of it as part of your portfolio. Just think of it as part of the stuff you buy that makes you happy. Thank you for listening. Meta Lutsoft is our producer. I want to say thank you to Rasmus for jumping into Meta's VIP line. I mean, for sending in your question. That didn't happen.

Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple, you can write us a review. If you've got a question for us, you can record it on your phone and send it in. We've got loads of them. I think we've got a listener question special or two coming up. But you can still make it. So send in your question. Who, me? You. Oh, you're talking to them. You can send one. I've got questions. You can send one too, Jack. You can send one. I've got questions. You can send one too, Jack. Thank you.

See you next week. It'll be awkward. See you next week.